It Isn’t All in Adam Smith

There’s nothing like staking out an extreme position to get the juices flowing. Take Harvard University professor N. Gregory Mankiw, writing in the most recent Journal of Economic Perspectives.

Asked what theoretical developments in macroeconomics had contributed to practice over the last thirty years, Mankiw, author of a leading introductory college text, answers, Next to nothing.

“The sad truth is that the macroeconomic research of the past three decades has had only minor impact on the practical analysis of monetary or fiscal policy,” Mankiw writes in a 17-page article.

It’s not that policy makers are ignorant of what has been done and said the past thirty years in research universities, he says. Some of the best young PhDs routinely head for the Federal Reserve System and the White House. Mankiw himself served as Chairman of the President’s Council of Economic Advisers from 2003 to 2005.

“The fact that modern macroeconomic research is not widely used in practical policy making is prima facie evidence that it is of little use for this purpose.”

Mankiw’s article — “The Macroeconomist as Scientist and Engineer” — appears as the second half of a symposium of a sort much favored by Perspectives. (The quarterly is supposed to fill a gap between purely academic journals and the general interest press.) The lead article — “Modern Macroeconomics in Theory and Practice: How Theory is Shaping Policy” — was written by V.V. Chari and Patrick Kehoe, both of the University of Minnesota.

The centerpiece of this discussion is, in the real world, the surprising transition, in the US and many other industrial countries, from high inflation rates in the 1970s to low rates for the last 25 years; and the virtual disappearance of hyperinflation elsewhere.

In the economics profession, the backdrop to these events is the argument between “new Classicals” and “new Keynesians,” which reached a boiling point twenty-five years ago, and then all but faded from view.

Chari and Kehoe advance what is by now the standard argument — that academic researchers learned a great deal during the 1970s, about central bank independence, transparency; credibility, inflation targeting and other rules to set monetary policy central banking; that some of what they learned found its way into policy; and that we are better off as a result.

They buttress their contention with a figure showing the dramatic differences in inflation rates in four countries between 1980 and 1990 under discretionary and targeting regimes — great peaks and valleys under the former, relative squiggles within the target zone under the latter.

Of course, Chari and Kehoe would say that. That is why they were invited to the symposium. They are from Minnesota, where many of the developments occurred or were vetted: formal insights contributed by Robert Lucas, Robert Barro, Edward Prescott, Finn Kydland and Thomas Sargent, elaborating on literary sparks originally struck in many cases by the original new Classical, Milton Friedman. (There has been a close alliance between the University of Chicago and Minneapolis for many years.) The authors promise a second wave of influence, as the significance of the new work becomes more widely understood, lending support for consumption rather than income taxes; and creating greater interest in the costs of policies that distort labor markets.

To these claims Mankiw’s response is strikingly nonchalant. For him, the great question remains, not the inflation of the 1970s, but the Great Depression — an economic downturn of such severity and duration as to threaten the continued existence of decentralized markets. Therefore he offers a simple dichotomy.

The early macroeconomists, those who adapted Keynesian insights to the task of managing the economy, may be viewed as problem-solvers, analogous to engineers. The new Classical macroeconomists of the past decades years have behaved more like scientists, interested in developing analytic tools and establishing theoretical principles than in their application to the real world.

For Mankiw, then, a major reason that economists stopped arguing about the causes of the business cycle was not to be found in the disinflation that was taking place around the world in the 1980s (at the direction of Paul Volcker and Alan Greenspan), nor in the two record expansions that followed, but rather in a famous exchange between Lucas and Robert Solow, in separate interviews given to Arjo Klamer, a Dutch economist, in 1982 and 1983. First Lucas told Klamer, “I don’t think that Solow, in particular, has ever tried to come to grips with any of these issues except by making jokes.”

A year later, Solow replied to Klamer, “Suppose someone sits down where you are sitting right now and announces to me that he is Napoleon Bonaparte. The last thing I want to do with him is to get involved in a technical discussion of cavalry tactics at the Battle of Austerlitz. If I do that, I’m getting tacitly drawn into the game that he is Napoleon Bonaparte.”

Mankiw writes, “Such vitriol among intellectual giants attracts attention, much in the way that patrons in a bar gather around a fistfight, egging on the participants. But it was not healthy for the field of macroeconomics. Not surprisingly, many young economists chose to avoid taking sides in this dispute by turning their attention away from economic fluctuations and toward other topics,” notably economic growth.

Similarly, for Mankiw, the place to discover whether the advances in macroeconomics reported by “self-congratulatory” scientists had actually improved, or at least altered, the conduct of monetary policy is to be found in Laurence Meyer’s 2004 memoir, A Term at the Fed. Meyer, 62, is an MIT-trained economist, and one of the nation’s most highly regarded forecasters. He served as a Fed governor from 1996 until 2002, an especially interesting period during which Alan Greenspan’s hunches drove monetary policy.

“The book leaves the reader with one clear impression,” reports Mankiw: “Recent developments in business cycle theory, promulgated by both new Classicals and new Keynesians, have had close to zero impact on practical policymaking.”

So much, then, for Inflation Targeting: Lessons from the International Experience, a 1999 compendium by Ben Bernanke, Thomas Laubach, Frederic Mishkin and Adam Posen. Surveying the record of the previous thirty years, the authors noted that both the experience of failed activist policies of the ’60s and ’70s and “intellectual developments” since then had contributed to an enhanced understanding of monetary policy. Bernanke today is chairman of the Federal Reserve, and Mishkin a governor.

Who can serve as arbiter of this debate? How about Lawrence Summers of Harvard University? For many years, Summers was identified as a new Keynesian, before he became a policy-maker and university president. In a piece about Friedman the other day (“If John Maynard Keynes was the most influential economist of the first half of the twentieth century, then Milton Friedman was the most influential economist of the second half”), Summers noted the new Classicals had more or less completely won the broad-gauge portion of the debate with the Keynesians.

“Fierce debates continue about how the Federal Reserve Board and other central banks should set monetary policy,” wrote Summers in The New York Times. “But the debates take place within the context of nearly complete agreement on some basics: Monetary policy can shape an economy more than budgetary policy can; extended high inflation will not lead to prosperity and can lead to lower living standards; policy makers cannot fine-tune their economies as they fluctuate.”

(One frequent dissenter from this consensus view is Columbia University’s Joseph Stiglitz, for whom an antipathy towards inflation is “a matter of religion, not economic science.” He writes, “There is simply little or no evidence that inflation, at the low to moderate rates that have prevailed in recent decades, has any significant harmful effects on output, employment, growth or the distribution of income.”)

There may be something to what Mankiw says. Certainly other people have reached the same conclusion. Thomas Sargent wrote an entire book critical of rational expectations triumphalism a few years ago (The Conquest of American Inflation.) Robert Gordon, Edmund Phelps, Rudiger Dornbusch and Stanley Fischer resurrected the Phillips Curve for policy-making purposes in the late 1970s, incorporating expectations and supply shocks oin their analysis. The human craving for narrative is very powerful. It is easy to find reasons where none exist, to be “fooled by randomness,” in Nassim Nicholas Teleb’s useful phrase (it is the title of his recent book).

But when Mankiw says that the new synthesis in economics — dynamic general equilibrium models with sticky prices and wages — “picks up the research agenda that the profession abandoned, at the behest of the new Classicals, in the 1970s,” he sounds remarkably like the complacent economists of an earlier age who, when asked if they had read any interesting papers recently, would aver, “It’s all in Marshall,” or “It’s all in Smith.” Greg Mankiw is a dedicated author, an enthusiastic teacher, a cheerful man who is not above poking fun on his blog at himself and his mates. But he is not the right economist to consult on the differences between engineering and science.